For the Fed, pros and cons of lowering yet another rate

Now that the Federal Reserve is finally – we think for real this time – preparing to reduce its bond buying program, trading floors are abuzz with what it could do at the same time to offset such a move. Tapering its quantitative easing (QE) program would signal, after all, that the Fed thinks the U.S. economy is healing and that monetary policy needn’t be as accommodative as it has been. But since inflation is still too low and unemployment is still too high, the thinking goes, the central bank will want to do something that proves it is serious about keeping interest rates low for a while longer in order to make sure the economic recovery is durable.

There are a handful of ways the Fed could say it still cares when it trims QE, be it this month or some time in the first half of next year. But one that has traders’ tongues wagging is cutting the interest rate the Fed pays banks on excess reserves. The so-called IOER has been set at 0.25 percent since the central bank introduced it in 2008, when the economy was on edge. With every additional asset the Fed buys under QE it creates reserves that the private banks often end up parking at the Fed itself, given rates are so low across the board. As it stands, reserves are $2.5 trillion and counting.

Cutting IOER from 0.25 percent could force more of those reserves into the broader financial system where they could act as loans that stimulate investment, hiring and economic growth. ”Most participants” at the Fed’s latest policy-setting meeting thought lowering the rate was “worth considering at some stage.” Yet concerns remain about tinkering with money markets at such a critical time, and policymakers are wary of trying to force banks’ hands in an untested way. For one, St. Louis Fed President James Bullard said last month he doubts the policy-setting Federal Open Market Committee (FOMC) would lower IOER unless a “sharp downturn” in the economy prompted such a move. Janet Yellen, who is set to become Fed chair next year, also appeared to downplay the option at a recent Senate confirmation hearing.

But that didn’t stop bond traders from peppering Simon Potter with questions on the chances of lowering IOER. Potter, who runs the New York Fed’s market operations and is thus the central bank’s point person for all things rates, had this to say Dec. 2 before a packed Money Marketeers dinner in lower Manhattan:

“The pros are that it is possible that you will get a small drop in short term rates. You might also get a signal of the policy intention of the FOMC because you’re taking an action, rather than promise to do something.

“The cons are well known: If you look back to 2003, when the Fed was looking at lowering interest rates (below 1 percent), they decided to go with 1 percent and the notion was that money markets don’t function that well at very low or even negative rates… and it could disintermeditate the whole financial system. I don’t think anyone is suggesting this. We believe the interest on excess reserves as set has been effective in preventing those market functioning (issues).”